So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/

If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.

A reader with considerable expertise weighs in with the following analysis of the events of late 2008. While this person has more expertise on this matter than anyone I know, he may not be completely unbiased, considering his employer ;-)

Steve - I do think you have it wrong. The plot line is false, but it is also imbued with plenty of facts - so explanation is difficult.

Quick summary: An AIG bankruptcy filing did not hinge on the resolution of these contracts, thus there could not have been a game of chicken.

Details (greatly simplied but still quite wordy): This story is set in November of 2008, but to understand it we have to go back two months earlier - to September. In September 2008 the clearing price of mortgage-backed securities implied a high rate of mortgage default with low recovery on foreclosed property - a decline in real estate values such as never seen before. Observers were still debating whether prices were correctly forecasting widespread defaults or whether prices were merely depressed due to illiquidity. For institutions levered to real estate the distinction was very important because it meant the difference between short-term liquidity problems and long run insolvency which would force bankruptcy.

To understand liquidity problems, we need to understand collateral. In order to minimize credit risk to each other, financial institutions ask for collateral from each other. As trades slowly move up or down in value, cash and securities flow between institutions so that everyone owes each other approximately nothing and the effects of a sudden bankruptcy are much smaller than they otherwise would be. Having collateral in hand means not having to worry about why your counterparty's trades are marking down so low - you are 100% insured by the collateral and if prices rebound you'll just give it back. And if your counterparty goes bankrupt you won't take a loss. Lehman was long real estate and, due to falling prices and having to post collateral, come September they ran out of cash. Regulators shopped them to other banks whose traders pored over Lehman's books and concluded "the company is insolvent, not just illiquid" so "goodnight Lehman Bros".

AIG was in the same boat as Lehman however AIG is an insurance company - this opened up three problems. (1) Banks are usually regulated by federal entities like the Fed and the SEC, so they all fit into similar frameworks nationwide. However insurance companies are only regulated by states. States are not particularly great at regulating because they are small and every state does things differently. (As a side note for fans of health care reform, regulating insurance companies at the federal level and creating national competition is the single most important reform needed. Lack of this in the so-called reform bills is proof that the legislation is all about creating health care entitlement without any real reform.) You can't just call in JP Morgan or Goldman Sachs to tell you what to do here because a bank can't really analyze an insurance company over a weekend. (2) Next, the ratings agencies had assigned AIG their highest rating, AAA, meaning that people who didn't want to do a lot of their own credit analysis, but didn't want to take any risk of default, were the sort of people who bought AIG bonds - that is to say, AIG bonds were largely being held in accounts that were presumed to be taking no risk by their owners. If you go back to news stories from September 2008 you will find many shrill voices invoking the spectre of systemic melt-down, but those voices tend to come from holders of AIG bonds, not random investors worried about "the system". (3) As an insurance company the general public was very broadly exposed to AIG in pensions, annuities, home insurance, etc... and these people aren't holding any collateral at all, but would account for a lot of votes at the polls come November. So, because of these three complications, the same politicians who let Lehman go under decided, at about the same time, to bail out AIG.

Now, there are lots of ways to do a bailout. This very same month, the largest financial entities in the world, Fannie and Freddie, were bailed out - and basically by the federal government saying "we simply guarantee all the debts and obligations of Fannie and Freddie". (Note that, in the end, the agency bailout is where the "taxpayer" will take almost all his lumps. But the politicians don't talk about this too much because Washington spent decades exempting Fannie and Freddie from any meaningful regulation and encouraging them, via various acts of congress, to facilitate mortgage loans to people who probably couldn't afford homes, but would make U.S. home ownership "more diverse".) In the case of AIG the bailout took the form of an $85 billion loan. It is important to remember at this point the debate over whether real estate securities were down because a bunch of mortage defaults were coming or just because nobody wanted to own the bonds. The politicians were still hoping for the latter and hoping that a loan would tide AIG through its illiquid period and into a time when the securities recovered. The TARP legislation was debated this same month, and the original intent of TARP was to buy these securities, thus creating a market for them, and a recovery in their prices. (In the end, however, TARP was not used in this way. It was used to invest in banks, for which no legislation was required anyway, and auto companies - which was probably illegal.) The TARP debate informs us that in September the politicians were not believing the market-implied rate of mortgage default. So, AIG used its bailout money to keep collateral flowing on its real estate positions. The thinking on this was that it stopped the counterparties from closing out the trades and thus "locking in the loss".

Now let's move forward to November 2008, the subject of this post. By November those debating that real estate securities were down due to illiquidity rather than coming defaults had given up their argument. A wave of defaults was coming and everyone finally realized that a lot of people who took out sub-prime mortgages always had the intention of defaulting because they didn't want to own a home so much as speculate on real estate going up. Back at AIG, their positions had continued to go against them and it became pretty obvious that AIG was insolvent, not just illiquid, and a more aggressive bailout was going to be needed if they were not to declare bankruptcy. But now if AIG goes bankrupt the government is in for a loss too since it has made all these loans. So "in for a penny in for a pound" the feds decide to up the bailout. Among many issues to be sorted out in the fresh bailout is that AIG still has all these real estate positions which keep bleeding money and, since AIG made the wrong calls on this all along, the feds decide to close out all of these positions.

At this point, the "unlimited bailout" decision has been made, and the discussion over mopping up these positions is a sidebar, not super important at the time (but it will become very politically sensitive a year later). The feds would like to save a few bucks by negotiating the close-out on these trades with the banks. However, because all the banks are holding lots of collateral, and some of them are even insured against AIG defaulting, they expect to be paid in full just like everyone else exposed to AIG. The feds aren't calling PIMCO and asking them to take 80 cents for their AIG bonds, they are calling retirees and asking them to take 80 cents for their pension annuities, and the aren't calling up auto insurance holders and asking them to take 80 cents for fender-bender repairs. Further, the insured banks wouldn't take a loss even if AIG went bankrupt unless you buy the end-of-the-world systemic melt-down scenario. But, even if you believe that, why aren't all of AIG's creditors being asked to contribute? Indeed, why not everyone in the world, since all benefit from there being no global melt-down. The banks are not the primary beneficiaries of the bailout, the bondholders are - bondholders have no collateral. In essence, there is nothing for the fed to negotiate, so they abandon the effort.

So, back to Steve's question. AIG was going to go bankrupt without a bailout, and negotiating 80 cents on the dollar for its real estate positions would not have changed that either way - so no game of chicken. For political reasons, the decision was made to bail them out. The banks were not asked to pay a disproportionate amount towards that bailout, and intelligent minds can debate whether or not they should have, but the case is far from clear. Lastly, I will add that I am unconvinced that letting AIG go bankrupt would have created a systemic meltdown, but it is clear why those involved in the bailout would say that. It is human nature that when you make a convenient but unpopular choice, your first defense is likely to be that you didn't really have a choice. The choice to bailout AIG was convenient and unpopular, but I don't agree that it would have led to systemic meltdown, and the historical arguments on my side are quite strong. Panics happen every 10 to 20 years and it is never the end of the world.

Saturday, January 30, 2010

This poignant video incorporates footage from the Bruce Weber documentary Let's Get Lost. Weber contrasted the age and drug ravaged Chet Baker of 1987 with the young, beautiful cult figure of the 1950s. The Santa Monica scenes have a suffused warm light that makes me yearn for Southern California.

Wikipedia: ... Entertainment Weekly ... said that Weber "created just about the only documentary that works like a novel, inviting you to read between the lines of Baker's personality until you touch the secret sadness at the heart of his beauty". ... Terrence Rafferty, in his review for the New York Times, wrote, "The enduring fascination of Let’s Get Lost, the reason it remains powerful even now, when every value it represents is gone, is that it’s among the few movies that deal with the mysterious, complicated emotional transactions involved in the creation of pop culture — and with the ambiguous process by which performers generate desire".

Although Let's Get Lost is out of print, you can find it in segments on YouTube. I'll never forget watching it with my girlfriend (also a jazz fan) in New Haven, back in the 1990s.

Thursday, January 28, 2010

Berkeley interview, 2001: ... I think the learning of history is a way of declaring, "I wasn't born yesterday; you can't deceive me." If I don't have any history, then whatever you, the person in authority, the president at the microphone announcing we must bomb here, we must go there, the president has the field all to himself. I cannot counteract, because I don't know any history. I can only believe him. I was born yesterday. What history does is give you enough data so that you can question anything that is said from on high. You can measure the claims that are being made by the people in authority against the reality. And you can look at similar claims that were made before, and see what happened then. Here's a president who's saying we're going to war for democracy. And then you go back through history and say, "How many times have presidents said we're going to war for democracy, and what have those wars really been about?" The history can clarify things, prepare you for dealing with the duplicities of the real world.

Wednesday, January 27, 2010

So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/

If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.

WSJ: ... The implicit deadline looming was Nov. 10, 2008, the day AIG was scheduled to report its third-quarter financial results. Fed officials knew the company's anticipated $25 billion quarterly loss wasn't going to be greeted favorably by major credit-rating firms, according to a person familiar with the matter.

Another downgrade would force AIG to pay out billions more to its counterparties and could give banks the right to terminate contracts and keep the collateral—moves that would likely send the insurer spiraling toward bankruptcy.

On Nov. 5, the New York Fed received a presentation, a 44-page analysis put together by a unit of BlackRock Inc., saying that the banks had significant bargaining power with AIG and had little incentive to cancel the contracts unless they received par, or 100 cents, on the dollar.

Sunday, January 24, 2010

The video from our December 2009 public discussion with Freeman Dyson is available here. (I think this should automatically stream if you have QuickTime, but otherwise you might end up downloading a 170MB .mov file.)

Saturday, January 23, 2010

NYU economist Dave Backus sends this link to an excellent interview with Raghuram Rajan, whose thinking we've referenced more than once on this blog.

In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.

“It is possible these developments may create ... a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”

It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on.

The careful study and willingness to challenge dogma Rajan displayed at Jackson Hole are in evidence throughout his work. As IMF chief economist, he produced controversial reports that questioned the efficacy of foreign aid and foreign investment. In 2003, he co-authored “Saving Capitalism from the Capitalists,” suggesting that government intervention is essential, not inimical, to market capitalism, but that it must be done right.

These days, policymakers listen carefully to Rajan—in May he testified before the Senate Banking Committee on the too-big-to-fail problem; he servesas economic adviser to the prime minister of India (his birthplace)—and not simply because of his insight on the recent financial crisis, but based on the quality of his scholarship. ...

I'd also like to highlight the following comments on an earlier post. They come from an experienced practitioner, originally trained in physics but with over 15 years on Wall Street and in the City.

First point - paying bonuses in equity is idiotic. The systemic risk is banks defaulting on their counterparties. Equity investors are prepared for a loss - because they are in it for the upside. Paying bonuses in equity encourages risk-taking - you get both upside and downside. Paying in deferred debt aligns the employees with the system - avoid risk, there is no upside! At all the blown-up shops the key players were all loaded up with equity. It is very frustrating to me that this obvious point is missed.

Second point - yes, making the banks have more capital is a great idea. There are clear metrics for capital and it would be trivial to regulate that the banks need to hold more. The failure of our government to do so is straightforward proof that the administration is purely political. What is the downside to asking all banks to have a 15% common capital ratio? Answer: none.

Thursday, January 21, 2010

If, like me, you are a fan of David Mamet, you will enjoy this lecture given at Stanford. It starts a bit slow but the Q&A at the end is good.

I'm not sure whether this link will work if you don't have iTunes. I couldn't find the podcast anywhere else on the web.

Stanford News: Judging from all the hardened characters and backstabbing that typify the works of David Mamet, one thing the Pulitzer Prize-winning playwright probably knows intuitively is how to entertain people by exploiting the follies of man.

He managed to do just that Jan. 28 during an evening talk titled "Art, Politics, Judaism and the Mind of David Mamet," held in Memorial Auditorium and presented by Hillel at Stanford and the ASSU Speakers Bureau.

Mamet, the writer behind the stage and screen versions of Glengarry Glen Ross, began by rushing through a typewritten speech that nominally addressed the aforementioned topics and several other loosely related issues.

Those included a rant on herd mentality, racism, the incompetence of government, how a liberal arts education delays an adolescent's matriculation into society and how humans are alike in their imperfect and immoral nature. Throughout, he was consistently clipped in tone and unapologetic about his views.

"In my racket, which is show business, one learns through doing and through watching. That's it," Mamet said. "There's no way to approximate the experience of failure in front of a paying audience." ...

Wednesday, January 20, 2010

... "Operation Aurora" is the latest in a series of attacks originating out of Mainland China. Previous attacks have been known as – "GhostNet" and "Titan Rain." Operation Aurora takes its name directly from the hackers this time – the name was coined after virus analysts found unique strings in some of the malware involved in the attack. These strings are debug symbol file paths in source code that has apparently been custom-written for these attacks.

... The compiler often offers other clues to a malware sample’s origin. For instance, if the binary uses a PE resource section, the resource’s headers will often provide a language code. The Hydraq component does use a resource section, but in this case, the author was careful to either compile the code on an English-language system, or they edited the language code in the binary after-the-fact. So outside of the fact that PRC IP addresses have been used as control servers in the attacks, there is no "hard evidence" of involvement of the PRC or any agents thereof.

There is one interesting clue in the Hydraq binary that points back to mainland China, however. While analyzing the samples, I noticed a CRC (cyclic redundancy check) algorithm that seemed somewhat unusual. CRCs are used to check for errors that might have been introduced into stored or transferred data. There are many different CRC algorithms and implementations of those algorithms, but this is one I had not previously seen in any of my reverse-engineering efforts.

... The CRC algorithm used in Hydraq uses a table of only 16 constants; basically a truncated version of the typical 256-value table. By decompiling the algorithm and searching the Internet for source code with similar constants, operations and a 16-value CRC table size, I was able to locate one instance of source code that fully matched the structural code implementation in Hydraq and also produced the same output when given the same input ...

... This source code was created to implement a 16-bit CRC algorithm compatible with the implementation known as "CRC-16 XMODEM", while requiring only a 16-value CRC table. It is actually a clever optimization of the standard CRC-16 reference code that allows the CRC-16 algorithm to be used in applications where memory is at a premium, such as hobby microcontrollers. Because the author used the C "int" type to store the CRC value, the number of bits in the output is dependent on the platform on which the code is compiled. In the case of Hydraq, which is a 32-bit Windows DLL, this CRC-16 implementation actually outputs a 32-bit value, which makes it compatible with neither existing CRC-16 nor CRC-32 implementations.

Perhaps the most interesting aspect of this source code sample is that it is of Chinese origin, released as part of a Chinese-language paper on optimizing CRC algorithms for use in microcontrollers. The full paper was published in simplified Chinese characters, and all existing references and publications of the sample source code seem to be exclusively on Chinese websites. This CRC-16 implementation seems to be virtually unknown outside of China, as shown by a Google search for one of the key variables, "crc_ta[16]". At the time of this writing, almost every page with meaningful content concerning the algorithm is Chinese ...

Tuesday, January 19, 2010

Did negotiators from French banks save Goldman from a haircut on its AIG CDS contracts? Or did Goldman save the French banks with its, um, connections to Paulson and other high places?

WSJ: The Federal Reserve's decision to pay billions of dollars to Goldman Sachs Group Inc. and other big banks as part of its bailout of American International Group Inc. has spawned criticism and conspiracy theories. Treasury Secretary Timothy Geithner, who presided over the New York Fed at the time, was summoned to Congress to explain why AIG paid off the $62.1 billion in soured derivatives in full, far more than they were worth in the market.

One element of the decision hasn't been well explored—how the Fed agreed to the full-payment demands of France's bank regulator and two of AIG's largest creditors, Société Générale SA and Calyon Securities, a unit of Crédit Agricole SA. The French banks and their regulator, it now appears, masterfully outmaneuvered the Americans to avoid discounts, or "haircuts," on their securities.

The French won the day by using a legal argument that some leading French scholars and corporate attorneys variously described in interviews as highly dubious and lacking real legal ground.

The banks and the regulator, known as the Commission Bancaire, said bank executives could be criminally liable for accepting a discount on their contracts, according to a November report of the inspector general of the Troubled Asset Relief Program.

While true in the abstract, "their argument was very overstated," said Pierre-Henri Conac, a University of Luxembourg law professor and a director of France's oldest corporate-law review. "Banks give haircuts every day."

French banks aren't always the best negotiators, Mr. Conac added, but this time "the French were very good."

...

The Fed and AIG finally seized on a plan, according to the inspector general's report. Step one: Let the banks keep $35 billion of collateral already posted by AIG. Two: Purchase the banks' underlying securities, which were derivatives tied to low-grade mortgages. Three: Cancel the contracts. Over one frenzied weekend in early November, Fed and AIG officials struggled with the final step: What should they pay for those securities? By contract, the banks were guaranteed full payment.

There were some factors to suggest a lower, negotiated price was in order. The securities' market value had fallen significantly. And absent the extraordinary U.S. bailout, AIG would have been in bankruptcy, potentially leaving counterparties with zero.

...

"To say that these people would have gone to jail if they cut a deal and signed the same agreement as Goldman Sachs is really pushing beyond what goes on in France," said Christopher Mesnooh, a partner at Paris's Fields Fisher Waterhouse who has authored a book on French corporate law.

"There is no clear-cut provision that would have prevented SocGen or Calyon" from negotiating a discount, said one of Paris' top lawyers, who asked not to be named because he works for the banks.

More information may shake loose as Congress continues its study of AIG. At the upcoming hearings, one can only hope the French role is carefully examined. There may well have been compelling reasons for making good on the $20.8 billion owed the French banks. But —as is now clear—not for the legal reason that the Fed and the French banks claim.

Sunday, January 17, 2010

This talk is a nice summary of Martin Jacques' recent book When China Rules the World. Jacques is insightful and his opinions are worthy of consideration. He combines the depth of an academic (he's a Cambridge PhD) with the willingness of a journalist and public intellectual (his job over the last 20+ years) to take chances and make broad statements. His late wife was an ethnic-Indian who worked as a barrister in Hong Kong. From her he developed a certain insight into aspects of Chinese society (specifically, attitudes toward race, ethnicity and cultures from the developing world) that would tend to elude a European intellectual. Jacques, who used to edit the journal Marxism Today, and was a strong critic of Thatcherism, nevertheless acknowledges the ascendancy of global capitalism ("is there any other game in town?"). Rather than hold his previous politics against him, it signals to me a certain mental flexibility. I'm more likely to trust the judgement of a thinker that has changed some of his fundamental assumptions in the face of facts. (Posterior probabilities should not equal prior probabilities after a nontrivial encounter with data -- if they do that is a clear warning sign; see some of the Chicago School interviews I linked to in the previous post ;-)

The audio is also available via iTunes as a podcast, and includes some Q&A at the end which challenges some of Jacques' assumptions. The Q&A is not included in the video below.

Synopsis:

For over two hundred years we have lived in a western-made world, one where the very notion of being modern was synonymous with being western. The book argues that the twenty-first century will be different: with the rise of increasingly powerful non-Western countries, the west will no longer be dominant and there will be many ways of being modern. In this new era of ‘contested modernity’ the central player will be China.

Martin Jacques argues that far from becoming a western-style society, China will remain highly distinctive. It is already having a far-reaching and much-discussed economic impact, but its political and cultural influence, which has hitherto been greatly neglected, will be at least as significant. Continental in size and mentality, and accounting for one fifth of humanity, China is not even a conventional nation-state but a ‘civilization-state’ whose imperatives, priorities and values are quite different. As it rapidly reassumes its traditional place at the centre of East Asia, the old tributary system will resurface in a modern form, contemporary ideas of racial hierarchy will be redrawn and China’s ages-old sense of superiority will reassert itself. China’s rise signals the end of the global dominance of the west and the emergence of a world which it will come to shape in a host of different ways and which will become increasingly disconcerting and unfamiliar to those who live in the west.

... All I am saying is that there are no easy answers in this thing … and one doesn’t have to be corrupt or in the pay of the financial sector to say, hey, wait a minute: it’s not as simple as letting them all go under or taking them all over. That’s my rant about the banking sector. By and large, I think we’ve done all the things that needed to be done. I think the downside of what we haven’t done is that we haven’t made the banks face up to more pain. That would have made it politically easier to do what needed to be done.

When you say, “make the banks face up to more pain,” what do you mean? Tougher regulation? Big equity stakes for the government—along the British lines?

Equity stakes and other things. For example, even now [the government] can require all compensation above a certain amount to be paid in equity, and equity that is real equity. The way banks do it now is they pay people in shares, but they also buy back equal amounts of shares [in the market]. So there is no increase in capital.

What we have right now is a situation where every saver in the country is, essentially, paying a huge tax to bail out the banking system. We are all getting screwed on our money market accounts—getting 0.25 per cent—and the banks are making a huge spread on nearly every asset they hold, because they are financing them at pretty close to zero rates. Another way of doing this—a way that would be nice to try—is to force the banks to load up on capital.

What is the point of all this? The point of all this is to get banks to lend. Well, they have been doing everything else except lending. Now, it may be that there aren’t that many profitable lending opportunities at this point. But if there aren’t, why are all the savers paying for this? Because you are not getting them to lend any more, and you are not getting more investment, which was the whole point of having interest rates so low. In fact, what you are doing is setting up a whole lot of other asset bubbles at this point.

Another way would be to put more direct pain on the banks. For example, if they were flush with capital and found they couldn’t pay bonuses, so all of this [money] went into increasing the capital base, they would have an incentive to make loans to reduce the effective capital that they had. What we have at the moment is that the citizenry is paying for the banks. Get the banks to pay for themselves.

That gets away from the whole Chicago issue. But what I’m arguing is in Chicago you have the extreme, which says, “Let the chips fall they may. What’s the problem with letting a few banks go under?” Whether you hold that view depends on how much you think the banks as an institution matters. Doug Diamond and I think it does matter. There is a lot of organizational and relationship capital embedded in the banks. If you let them go, it is very hard to start them up [again].

I think the average person can (maybe) grasp that we want to recapitalize the banking system, but I don't think anyone understands why bankers should be getting record bonuses just a year or two after nearly destroying our economy and suffering losses equal to many past years of "earnings" that they've already been paid for.

Thursday, January 14, 2010

McAfee dissects the exploit used against Google and other companies operating in China. Given the "social vector" used for initial penetration -- sending emails that appear to come from close associates -- there is an obvious motivation for these hackers to get access to gmail accounts. What's the evidence that this had anything to do with the Chinese government? The McAfee report is careful not to speculate.

If I were a Chinese hacker, wouldn't the filepaths on my development machine have non-English (unicode) characters? I'm sure some readers of this blog would know -- if you develop software in a Chinese language environment, do you use English words or Chinese characters for path and directory names?

Of course, it's possible the attackers just bought the malware from a black hat developer somewhere or have deliberately obfuscated the origin of their code. We need some more forensic information...

McAfee Security Insights Blog: ... the intruders gained access to an organization by sending a tailored attack to one or a few targeted individuals. We suspect these individuals were targeted because they likely had access to valuable intellectual property. These attacks will look like they come from a trusted source, leading the target to fall for the trap and clicking a link or file. That’s when the exploitation takes place, using the vulnerability in Microsoft’s Internet Explorer.

Once the malware is downloaded and installed, it opens a back door that allows the attacker to perform reconnaissance and gain complete control over the compromised system. The attacker can now identify high value targets and start to siphon off valuable data from the company. ...

Operation “Aurora”

I am sure you are wondering about the name “Aurora.” Based on our analysis, “Aurora” was part of the filepath on the attacker’s machine that was included in two of the malware binaries that we have confirmed are associated with the attack. That filepath is typically inserted by code compilers to indicate where debug symbols and source code are located on the machine of the developer. We believe the name was the internal name the attacker(s) gave to this operation. ...

WSJ reports on the decision process at Google. There are still a number of open questions:

1. What were Google's prospects in China? Are they really hopelessly behind Baidu? I've seen market share estimates ranging from 15-30% (no agreement even on the sign of the derivative!), and also the claim that the most sophisticated users (i.e., the ones with the most disposable income in the long run) tended to use Google. Perhaps no reason to throw in the towel -- but then why did Kai Fu Lee resign in September? Was it just the opportunity to run his own investment fund? (Here is an earlier post on Baidu, with a talk given by founder Robin Li.)

2. How serious is the state-sponsored security threat to companies operating in China? Did this play a big role in Google's decision? Coordinated attacks by state-run intelligence are significantly harder to deal with than ordinary hackers or even corporate espionage. An intelligence agency only has to turn a few key employees to get at important source code that necessarily would have to be available to researchers and operations people at Google China. It would be difficult to justify the risks of operating in an environment that hostile. (Needless to say, it would be long-run detrimental for China to create an environment that hostile to foreign companies.) On the other hand, snooping around for information about a few email users is hardly a threat of the same proportions.

WSJ: Google Inc.'s startling threat to withdraw from China was an intensely personal decision, drawing its celebrated founders and other top executives into a debate over the right way to confront the issues of censorship and cyber security.

The blog post Tuesday that revealed Google's very public response to what it called a "highly sophisticated and targeted attack on our corporate infrastructure originating from China" was crafted over a period of weeks, with heavy involvement from Google's co-founders, Larry Page and Sergey Brin.

For the two men, China has always been a sensitive topic. Mr. Brin has long confided in friends and Google colleagues of his ambivalence in doing business in China, noting that his early childhood in Russia exacerbated the moral dilemma of cooperating with government censorship, people who have spoken to him said. Over the years, Mr. Brin has served as Google's unofficial corporate conscience, the protector of its motto "Don't be Evil."

The investigation into the cyber intrusion began weeks ago, although how Google detected it remains unclear. As Google employees gathered more evidence they believed linked the attack to China and Chinese authorities, Chief Executive Eric Schmidt, along with Messrs. Page and Brin, began discussing how they should respond, entering into an intense debate over whether it was better to stay in China and do what they can to change the regime from within, or whether to leave, according to people familiar with the discussions. A Google spokesman said Messrs. Page, Brin and Schmidt wouldn't comment.

Mr. Schmidt made the argument he long has, according to these people, namely that it is moral to do business in China in an effort to try to open up the regime. Mr. Brin strenuously argued the other side, namely that the company had done enough trying and that it could no longer justify censoring its search results.

How the debate ultimately resolved itself remains unclear. The three ultimately agreed they should disclose the attack publicly, trying to break with what they saw as a conspiratorial culture of companies keeping silent about attacks of this nature, according to one person familiar with the matter.

Soon, Google's vice president of public policy and communications, Rachel Whetstone, began crafting and revising a number of versions of a possible statement the company planned to release publicly, these people said, sharing it with the three.

The top three agreed that in addition to discussing the attack, the blog post should contain some language about human rights, the strongest statement of which is a clause in the penultimate paragraph of the post.

The section said they had reached the decision to re-evaluate their business in China after considering the attacks "combined with the attempts over the past year to further limit free speech on the web."

Concerned about potential retribution against Google employees in China, the founders and their advisors agreed to include a line saying that the move was "driven by our executives in the United States, without the knowledge or involvement of our employees in China."

... Veteran observers of trade between the countries suggest that Google, and the U.S. generally, has little leverage to press China to back down on Internet censorship or other issues.

Some expressions of support for Google's position flowed in from around the world, including from consumers in China as well as some U.S. companies—including rival Yahoo Inc.—and politicians. Secretary of State Hillary Clinton Tuesday issued a statement saying Google's allegations "raise very serious concerns and questions," and that "we look to the Chinese government for an explanation."

Odds are high Google could be left largely on its own in taking concrete steps to confront the Chinese government. Veteran observers of trade between the countries suggest that Google, and the U.S. generally, has very little leverage to press China to back down on Internet censorship or other issues.

Besides the Google.cn Web site, Google has a range of other business initiatives and partnerships in China that could be affected by its decision. By snubbing Chinese authorities so publicly, the company risks government retaliation against itself or its partners. The decision also affects local competitors who could benefit from any retreat. Shares of Google's biggest Chinese rival, Baidu Inc., surged following the news.

Google's blog post Tuesday said cyber-attacks on its infrastructure resulted in "the theft of intellectual property," stating that it found evidence to suggest that a primary goal of the attackers was accessing the Gmail accounts of Chinese human-rights activists.

Again, snooping on activists and stealing core IP are two very different activities. Which was more disturbing to Google? Previous discussion here.

“Don’t Be Evil” always did sound a bit to me like tikkun olam, or repairing the world (see this profile of Brin and Page). Not sure whether CEO Schmidt is down with that ;-)

Wednesday, January 13, 2010

1. Google’s business was not doing well in China. Does anyone really think Google would be doing this if it had top market share in the country? For one thing, I’d guess that would open them up to shareholder lawsuits. Google is a for-profit, publicly-held company at the end of the day. When I met with Google’s former head of China Kai-fu Lee in Beijing last October, he noted that one reason he left Google was that it was clear the company was never going to substantially increase its market share or beat Baidu. Google has clearly decided doing business in China isn’t worth it, and are turning what would be a negative into a marketing positive for its business in the rest of the world.

2. Google is ready to burn bridges. This is not how negotiations are done in China, and Google has done well enough there to know that. You don’t get results by pressuring the government in a public, English-language blog post. If Google were indeed still working with the government this letter would not have been posted because it has likely slammed every door shut, as a long-time entrepreneur in China Marc van der Chijs and many others said on Twitter. This was a scorched earth move, aimed at buying Google some good will in the rest of the world; Chinese customers and staff were essentially just thrown under the bus.

Actually, recent reports estimate their 2009 search market share at around 30 percent, which is nothing to sneeze at. They could have had a good business in China, although I agree with Kai Fu Lee that the government would never let them dominate the market there the way they do in the rest of the world.

The hacking used trojans injected via a zero-day vulnerability in Adobe (PDF file attachments) [Edit: or was it an IE browser problem? And were the hackers really Chinese -- why codename Aurora?]. The claim that these attacks on multiple companies were coordinated by Chinese intelligence services is plausible but far from proven.

It's important to emphasize that the Chinese government is not monolithic. The parts of the government concerned with economic growth and technology development will be asking some hard questions of the intelligence apparatus about this. No economic planner wants high tech companies like Google or Adobe to stop operating in China as a consequence of security risks.

Tuesday, January 12, 2010

The top story on the Times web site today is about the assassination of a physicist at Tehran University.

A remote-controlled bomb attached to a motorcycle killed an Iranian physics professor outside his home in northern Tehran on Tuesday, state media reported, blaming the United States and Israel for the attack.

There was no immediate claim of responsibility. One state broadcaster, IRIB, quoted a Foreign Ministry spokesman as saying that “in the initial investigation, signs of the triangle of wickedness by the Zionist regime, America and their hired agents are visible in the terrorist act” against the scientist, Massoud Ali Mohammadi.

... The Web site of Iran’s state television declared the bombing a “terrorist act by counterrevolutionaries and elements of arrogance,” a reference to the United States. Security forces are investigating, The A.P. quoted the report as saying.

The United States and western allies have been pressing Iran to halt its nuclear enrichment program, which Tehran insists is solely for civilian purposes to produce electricity. But the West fears Iran is seeking to build a nuclear weapon that would threaten Israel and upset the regional power balance.

Last year, an Iranian nuclear scientist, Shahram Amiri, disappeared during a pilgrimage to Saudi Arabia; Iran accused the United States of helping to kidnap him.

After Tuesday’s explosion, the government’s supporters and opponents traded accusations and claims that the scientist had supported their camp.

Here is a picture of the victim. My condolences to his family and friends.

His recent publication list (below) does not suggest he was involved in the bomb program, although you never know what people do in their spare time. If I had to guess I would suppose he was killed for being pro-reform.

More details at the blog post here. Coincidentally, I first learned quantum mechanics (during high school) from the Iowa State University Professor Hauptman mentioned at the link. He is a high energy experimentalist and his work has no near-term military applications.

When I was growing up my father, a professor, had graduate students from Iran. I remember attending a traditional Iranian wedding. One of the students pointed to another guest, saying to me, "Look, he is SAVAK" -- referring to the Shah's secret police.

Saturday, January 09, 2010

Some interesting numbers from this blog post by a software industry veteran operating in China. As a rule of thumb, it seemed to me that in non-tourist Beijing the buying power of a yuan (1 rmb) was very roughly equivalent to a dollar here: a cheap meal for 5-10 rmb, a supermarket beer for 1 rmb, etc. So, even at the 5 to 1 labor arbitrage rate suggested below a software developer in China has roughly similar buying power in local products as a developer here in the US (current exchange rate is 6-7 rmb per dollar). Of course, that buying power equivalence doesn't apply to "tradeables" like laptops, gasoline, automobiles, etc.

In the National Academies Press 2005 report, Rising Above The Gathering Storm, it was noted that "for the cost of one chemist or engineer in the U.S., a company can hire about five chemists in China or 11 engineers in India." In fact, I have personally observed that the labor arbitrage difference is the largest in an absolute sense the higher a firm opts to go on the value chain. For example, a Ph.D. who is paid $125 per hour in the States (whether fully-burdened or on contract) can be billed at about $25 per hour, whereas a $75 per hour Java programmer (an average Joe Java programmer, not a superstar) can be billed at between $16-18 per hour. And a superstar Java programmer: $100-125 per hour in the States, whereas a Tsinghua equivalent is billable by us at $20-23 per hour. As to the 11-to-1 ratio noted by the COSEPUP report, it's certainly doable (not always, but sometimes) in certain areas such as software testing where talent in Tier 2 cites can be tapped. Advice: Don't go to Beijing, Shanghai or Shenzhen for software testing or localization/globalization. And even though I personally don't like BJ, the best high-end talent is in BJ, not in SH, SZ, DL (Dalian), or anywhere else in the mainland.

New Yorker economics correspondent John Cassidy has a very balanced piece about the impact of the credit crisis on thinking at The Chicago School. He also uses the term apostasy to describe Posner's turn toward Keynes.

In the article, Heckman, Becker and Rajan seem the most reasonable. Fama is obviously clinging to his priors and Lucas refused to talk to Cassidy.

Cassidy makes additional remarks on his blog, and promises in the near future to publish more detailed notes on the interviews he did with the Chicago economists.

... For people interested in the subject, and there seems to be a lot of you, the good news is that I’m planning on posting here much fuller versions of the interviews I did in Chicago, with the likes of Gene Fama, Gary Becker, and Richard Posner, who recently converted to Keynesianism. It’s the nature of long-form magazine journalism that a lot of interesting stuff gets left out of the finished article, but, thanks to the Web, there’s no reason it shouldn’t appear in some form. Plus, I think it’s a good time to let the Chicago economists speak for themselves. Over the last couple of years, they have taken a battering at the hands of myself, Paul Krugman, Joe Stiglitz, and others. Having just finished writing a book entitled “How Markets Fail,” I went to the Windy City eager to learn first hand how the critiques of Chicago economics were being received. Some of what I was told, I don’t agree with, but at this time of intellectual tumult I think it makes fascinating reading.

In the article Posner notes that few economists knew anything about how real financial markets work. This is certainly true in my experience. In particular, they were naive about individual incentives within the system (see Greenspan comments), and very few academics (with perhaps one or two exceptions; video) had any idea what a CDO or CDS was before 2008. I can't resist a little sniping here. If you want to ask someone about electrons, or how to build a quantum logic gate, or how to fabricate nanostructures, you can't do much better than to head to your local research university and talk to a physics professor. Strangely, if I wanted to learn something about credit markets or securitization or the risk from speculative bubbles, I would have been better off talking to a former physicist on Wall St. than to almost any professor in an economics department or business school. I'm not exaggerating -- I've done both many times. Posner also says:

"Well, one possibility is that they [the economists] have learned nothing [from the financial crisis] ... Because -- how should I put it -- because market correctives work very slowly in dealing with academic markets. Professors have tenure. ... It takes a great deal to drive them out of their accustomed way of doing business."

Thursday, January 07, 2010

Is Wikipedia a magical aggregator and filter of expertise from millions of different contributors? Or is it more like traditional encyclopedia projects, with a thousand or so core Wikipedians doing most of the work? The distribution of edits (a typical power law) supports the latter interpretation, but a detailed analysis of particular articles shows that important knowledge is injected by individuals who are not part of the core group.

Aaron Swartz: I first met Jimbo Wales, the face of Wikipedia, when he came to speak at Stanford. Wales told us about Wikipedia’s history, technology, and culture, but one thing he said stands out. “The idea that a lot of people have of Wikipedia,” he noted, “is that it’s some emergent phenomenon — the wisdom of mobs, swarm intelligence, that sort of thing — thousands and thousands of individual users each adding a little bit of content and out of this emerges a coherent body of work.”† But, he insisted, the truth was rather different: Wikipedia was actually written by “a community … a dedicated group of a few hundred volunteers” where “I know all of them and they all know each other”. Really, “it’s much like any traditional organization.”

The difference, of course, is crucial. Not just for the public, who wants to know how a grand thing like Wikipedia actually gets written, but also for Wales, who wants to know how to run the site. “For me this is really important, because I spend a lot of time listening to those four or five hundred and if … those people were just a bunch of people talking … maybe I can just safely ignore them when setting policy” and instead worry about “the million people writing a sentence each”.

So did the Gang of 500 actually write Wikipedia? Wales decided to run a simple study to find out: he counted who made the most edits to the site. “I expected to find something like an 80-20 rule: 80% of the work being done by 20% of the users, just because that seems to come up a lot. But it’s actually much, much tighter than that: it turns out over 50% of all the edits are done by just .7% of the users … 524 people. … And in fact the most active 2%, which is 1400 people, have done 73.4% of all the edits.” The remaining 25% of edits, he said, were from “people who [are] contributing … a minor change of a fact or a minor spelling fix … or something like that.” ...

[But what if we analyze the amount of text contributed by each person, not just the number of edits? See original for analysis of edit patterns of specific articles, including amount of text added.]

... When you put it all together, the story become clear: an outsider makes one edit to add a chunk of information, then insiders make several edits tweaking and reformatting it. In addition, insiders rack up thousands of edits doing things like changing the name of a category across the entire site — the kind of thing only insiders deeply care about. As a result, insiders account for the vast majority of the edits. But it’s the outsiders who provide nearly all of the content.

And when you think about it, this makes perfect sense. Writing an encyclopedia is hard. To do anywhere near a decent job, you have to know a great deal of information about an incredibly wide variety of subjects. Writing so much text is difficult, but doing all the background research seems impossible.

On the other hand, everyone has a bunch of obscure things that, for one reason or another, they’ve come to know well. So they share them, clicking the edit link and adding a paragraph or two to Wikipedia. At the same time, a small number of people have become particularly involved in Wikipedia itself, learning its policies and special syntax, and spending their time tweaking the contributions of everybody else.

Wednesday, January 06, 2010

I did this interview with Andrew Warner, an entrepreneur whose web site mixergy.com aims to help other business innovators. Andrew and I both ran tech startups "back in the day" and got to experience the Internet Bubble first hand :-)

Tuesday, January 05, 2010

I'm currently chairing a faculty search, and I got into a conversation with a colleague on the topic of what psychologists would call personnel selection. I've seen studies which show that people are typically very overconfident in their judgements of candidates based on informal interviews or initial impressions, and that the structured and quantitative measure-based selection method used by firms like Google tends to be the most effective. Most professors, of course, don't want to hear this -- they seem quite confident in their own heuristics :-)

I'm open to the possibility that the traditional process is still the best way to select a colleague. But has anyone studied this question? Is anyone familiar with the personnel selection literature as applied to high-end positions like scientists, professors and researchers?

This article summarizes the practical and theoretical implications of 85 years of research in personnel selection. On the basis of meta-analytic findings, this article presents the validity of 19 selection procedures for predicting job performance and training performance and the validity of paired combinations of general mental ability (GMA) and Ihe 18 other selection procedures. Overall, the 3 combinations with the highest multivariate validity and utility for job performance were GMA plus a work sample test (mean validity of .63), GMA plus an integrity test (mean validity of .65), and GMA plus a structured interview (mean validity of .63). A further advantage of the latter 2 combinations is that they can be used for both entry level selection and selection of experienced employees. The practical utility implications of these summary findings are substantial. The implications of these research findings for the development of theories of job performance are discussed.

... As noted above, GMA is also an excellent predictor of job-related learning. It has been found to have high and essentially equal predictive validity for performance (amount learned) in job training programs for jobs at all job levels studied. In the U.S. Department of Labor research, the average predictive validity performance in job training programs was .56 (Hunter & Hunter, 1984, Table 2); this is the figure entered in Table 2. Thus, when an employer uses GMA to select employees who will have a high level of performance on the job, that employer is also selecting those who will learn the most from job training programs and will acquire job knowledge faster from experience ... Because of its special status, GMA can be considered the primary personnel measure for hiring decisions, and one can consider the remaining 18 personnel measures as supplements to GMA measures.

Sunday, January 03, 2010

Science 11 July 2008: A new study has found that the most likely undergraduate alma mater for those who earned a Ph.D. in 2006 from a U.S. university was … Tsinghua University. Peking University, its neighbor in the Chinese capital, ranks second. Between 2004 and 2006, those two schools overtook the University of California, Berkeley, as the most fertile training ground for U.S. Ph.D.s (see graph). South Korea's Seoul National University occupies fourth place behind Berkeley, followed by Cornell University and the University of Michigan, Ann Arbor.

Of course, the schools listed above all have large enrollments. If you normalize by undergraduate population the top school is Caltech. (Almost 40 percent of Caltech undergrads go on to earn a doctorate.)

I was at Tsinghua in December. Surprisingly, they don't heat the buildings in winter -- even the school of management had freezing cold hallways (individual offices and classrooms are heated). It seems brutal, but it's very green! Apparently 40 percent of the US energy budget goes to heating and cooling buildings. Just look at your winter heating bill and you can understand why central heating is a luxury in developing countries (energy is a tradeable).

What a cool idea! Adjustable spectacles for about 4 Euros -- a potential benefit to hundreds of millions of poor people around the world with vision problems. See this Times article for more.

One design is based on the Alvarez Lens, invented by Berkeley physicist Luis Alvarez (an amazingly creative guy!). See here for other adjustable lens mechanisms.

I need to stockpile some of these just in case society collapses...

I'm at an age when an increasing number of my former classmates and colleagues, after being trained in science and earning their fortunes in finance or technology startups, are starting to retire! If you're looking for a way to give back to society, why not work on or contribute to a project like this one?

U-spec: Whereas normal spectacles contain fixed, single lenses, the U-Spec lenses are formed from two complementary parts mounted together. The complexly curved surface of these parts resembles a saddle, with a hollow to one side and a little "hill" to the other. These two parts can fit together with the hill of one sitting in the hollow of the other, but they can also slide apart in opposite directions. The key thing is that in any configuration they together form a viable lens for assisting defective eyesight, with the power of the lens changing depending on their position.

It may sound complicated, but for the wearer of the U-Spec adjusting the lenses couldn't be easier. You simply close one eye at a time and find the correct focus for the other by sliding a small knob up and down in a vertical slot in the frame, next to the lens in question.

DIY optometry"People wearing these spectacles can look at a far away object and move the knob until they have it sharp," says Dr van der Heijde. "You don't need a specialist to get good spectacles, you can do it yourself — and that's a good opportunity to have in Third World countries."

U-specs.org: The principle of the universal spectacles is based on the discovery of Alvarez, an American who, in 1968, won the Nobel Prize in the field of high-energy Physics. The lens is composed of two moveable parts with a flat surface facing each other and “saddle form“ outer surfaces (see fig. 1). Alvarez mathematically demonstrated in 1964 that the refractive power of the combined lenses vary proportionally with the amount of relative movement of the lens parts.

Friday, January 01, 2010

Eugene from our bedroom deck. In the larger version (click) you can see the UO football stadium across the river from us, about 3 miles away. The Ducks play Ohio State in the Rose Bowl later today.

When I came to Oregon from Yale a decade ago, I also had an offer from Wisconsin. But a visit in April to Madison (gray, snow, yuck) was enough to convince me to follow my instincts and head further west.

This is my son's first attempt at fixed-wing aircraft design :-) He built it all by himself -- I was a little surprised when he showed it to me!